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Coming through with a real tax cut in 2001 could have changed everything (Image by cliff1066™ via Flickr)

What caused the crisis of 2008, which we still live with today in the form of 1% growth and 9% unemployment? The common answer is that the crisis resulted from congenital issues. Our form of capitalism is flawed, our nation is in the early onset of dotage, the free-market revolution of a generation ago set the thing in motion – nearly all of the general explanations of what brought the crisis on contend that it was long in coming, that it was in our bones.

We should be more curious about the intermediate and short-term causes. After all, once historians get hold of economic crises of years past, they inevitably point to proximate causes that, had they been altered at the time, would have not led to crisis but to the perpetuation of a healthy economic cycle.

This time will prove no different. What’s been missing in all the analysis of the origins of the crash of 2008 is discussion of the ossification of macroeconomic policy that occurred in the presidential transition eight years before.

How odd the election of 2000 was. That year the United States was riding a spectacular eight-year wave of good growth, with the stock market peaking at three times its level from when the outgoing president, Bill Clinton, had first run for president in 1992. And if we recall that the Dow peaked in March 2000, we should remember that the S&P nearly touched an all-time high as late as August of that year.

On the fiscal side, federal spending plunged to a 34-year low as a percentage of GDP (if on the back of the defense department), and the year’s budget surplus came in at a whopping $236 billion. How Bill Clinton’s anointed successor, Al Gore, wouldn’t cakewalk to the presidency in these conditions was a valid question.

But cakewalk he did not. In early spring, his Republican rival George W. Bush called for a tax cut, and thereafter the two were locked in a tight race, a race that ultimately came down in Bush’s favor by a few hundred votes in the deciding state of Florida.

Had Gore called for a tax cut in the 2000 campaign, it is inconceivable that he would have lost. If taxes cannot be cut when there is such a huge surplus, when can they ever? It was illogical for Gore to insist on current tax rates. The electorate sifted through the illogic, and Bush entered the White House.

But then, amazingly, Bush hesitated on his signature campaign pledge. He timidly asked Congress, closely divided between the parties, for a tax cut, and made sure that it favored lower-income earners. The marginal rate of the income tax went down all of 0.5%, from 39.6% to 39.1%. Also, the president indicated that his “compassionate conservatism” would lead to higher spending.

All the while in 2000, as the stock market was treading water in the context of the mammoth surplus and the electoral contest over fiscal policy, it was indicating that investors wanted to see what would ensue. What came was poorly-crafted tax policy and movement to gobble up the surplus on the spending side.

The semi-great crash of 2001-2003 started a few months before 9/11, another thing we are apt to forget. Recession also came (though not two consecutive quarters of GDP decline). It was in these conditions that the Federal Reserve stepped in to try to pick up the slack since fiscal policy had gotten weird. It was then, 2001-2003, that the Fed plumbed new lows in the federal funds rate, holding it full points below what the widely regarded Taylor Rule said that rate should be.